Whole life policies have cash value that can be accessed by the owner of the policy via a transaction commonly known as a policy loan, although it would be more accurately described as a policy lien. Term policies have no cash value and hence cannot be borrowed upon.
The question I hear often is “Why do I have to borrow my own money?” As stated in a prior email, the cash value is technically owned by the insurance company, not the owner of the policy. That fact comes as a surprise to many people, because whole life is so often described by the media as “insurance with a savings fund”, but as I’ve said many times, that is not true; it is just an analogy, and a very poor one at that. (Shocking, I know, that the media gets a story wrong.)
The cash value of a whole life policy is a reserve to pay the future death claim, but the insurance companies make that reserve available to the policy owners via a policy loan. It is unfortunate that the transaction is termed a loan, because it is the only loan that I’m aware of that is available just for the asking (insert sub-prime joke here).
The reason no qualification is required for the loan is because it is actually just a lien against the death benefit. That is also the reason the insurance company doesn’t care if it is ever repaid. If a policy with an outstanding loan matures in a death claim, the amount of the loan will be subtracted from the death benefit. Likewise, if a policy with an outstanding loan is surrendered, the cash value payable will be net of the loan.
Interest is charged on the loan because the insurance company uses the reserve and the earnings on the reserve to pay the claim. To the extent reserves are loaned, the insurance company loses the ability to invest those dollars, so the interest charge makes up (theoretically) for lost earnings.
To summarize, the cash value of a life insurance policy is available to the policy owner in the form of a loan. It is important to remember that the loan reduces the death benefit while it’s outstanding (it can be, but need not be, repaid), and an annual interest charge will be incurred until the loan is repaid.